Franchises: Experience the concept before signing

June 2012

The resounding success of several types of franchises, and in particular fast-food franchises, continues to spark the interest of entrepreneurs and financial institutions. The franchise concept also meets several criteria of people who want to start up a business with little experience. Its appeal includes:

an acceptable initial capital investment with good financing possibilities offered by the franchisor or financial institutions, which are becoming more familiar with the concept;

quality products recognized and respected by the public with known brands

pre-established procedures as well as accounting and audit systems which give franchisees better control of their costs

products supplied by a single supplier designated by the franchisor

the example of other franchisees shows the viability of the concept and the potential of a very acceptable return

There are two ways to acquire a franchise: negotiate directly with the franchisor or purchase a business from a franchisee. In each case, the purchaser should conduct a due diligence which includes some of the following preliminary steps:

Obtaining from the franchisor all the documentation which he will have to sign in connection with the franchise contract. This documentation should be sent to your legal adviser so he can inform you of your rights and obligations in connection with the operation of the franchise and the franchiser’s conditions for becoming a member of its network. He can also tell you what corporate structure is best adapted to your proposed franchise.

Steps must be undertaken with one or more financial institutions to confirm the availability of the capital you will need to purchase the franchise. This exercise will identify the borrowing costs as well as the related terms, i.e. the type of security, bonds or other undertakings the financial institution may require from the borrower before granting such a loan.

Meet with franchisees who are already operating businesses under the banner you are interested in. These people can give you certain financial data about their operations and tell you about any difficulties they had setting up their business or with its day-to-day operations as well as the support provided by the franchisor.

During meetings with financial institutions or other franchisees, it is important to be accompanied by your legal adviser. The information you receive together will help you build a better business plan and assess the business risk involved with the transaction more objectively.

Spending a few days with a franchisee of the banner you are interested will allow you to experience the pace of the business, its daily operations, and to verify the interactions between customers and employees. This crucial experience, depending on the circumstances, could confirm that you are making the right choice. If not, you can always stop the process at this stage before suffering any significant loss.

It is also prudent to visit the future location chosen by the franchisor if it has not been built yet. Walk around the site, see what kind of neighbourhood it is (industrial, commercial or residential), and analyze the flow of traffic and people’s habits on a given day. This will help you determine how busy your future business will be.

Check in the documentation whether the franchisor gives you exclusivity for a given territory. If not, find out from other franchisees what the franchisor’s attitude is in this regard.

Check whether the owner of the site where several businesses are located has given your franchisor exclusivity for the sale of the products and services offered by your franchise. This will ensure that you don’t have to deal with a competitor who could significantly affect your sales. If this is not the case, the franchiser’s offer should be considered much less attractive.

Everyone considering buying a franchise is excited about their new venture but this enthusiasm can prevent you from properly assessing the difficulties you will face. These preliminary steps can help you see more clearly and possibly encourage you to be more thorough in your analysis and in your negotiations with the franchisor, although it should be kept in mind that a franchise is a contract of adhesion and that it is difficult for a franchisee to derogate from it.

In short, a franchisee must be convinced that the franchiser’s proposal is acceptable and that it will allow him to earn the expected profit given the capital he is investing and the obligations he will have to bear during the franchise contract.

If you are thinking of buying a business directly from a franchisee, the preliminary steps mentioned above should also be taken, adapting them as necessary. However, you should realize that the negotiations will be three-way: between yourself, the franchisee-vendor and the franchisor.

Most franchise contracts provide for a right of first refusal in favour of the franchisor if the franchisee’s business is sold. It would be advisable to have the franchisor waive its right of first refusal and authorize you to negotiate with the franchisee-vendor.

Each situation requires specific and timely steps and it is up to you to obtain from the franchisee, for example, any other information you may require to properly assess the proposed transaction and find out why this franchisee-vendor has decided to stop operating his franchise.

Once again, this exercise should be carried out with your lawyer who will help you collect the information and, where applicable, conduct the negotiations and enter into an agreement which will meet your goals and those of the franchisor.

As the franchise concept is constantly evolving, business people are turning to experts in this area more and more often, since this type of contract provides that business operations will be carried out in a very defined framework (uniform standards) and according to regulatory requirements applicable to the industry. At De Grandpré Chait, our lawyers are regularly asked to advise clients in this regard and represent a benchmark in terms of the skills and efficiency required to properly advise and accompany an entrepreneur in such matters.

This bulletin provides general comments on recent developments in the law. It does not constitute and should not be viewed as legal advice. No legal action should be taken on the basis of the information contained herein.